In honor of Nobel Laureate Richard Thaler’s famous book Nudge turning 10, Aishwarya Deshpande (Economics ’18) writes in Behavioral Scientist magazine about the emerging subfield in development economics, namely behavioral development economics. The subfield aims to incorporate insights informed by behavioral science to address issues of persistent inequality, poverty alleviation and welfare.
Aishwarya had the pleasure of reading various academic papers that addressed these issues with innovative approaches in preparation for the essay. She finds that ‘last mile’ between intention and action can be bridged by understanding the limitations of the human mind, which potentially has many policymaking implications.
Behavioral science has come a long way in the past 50 years. While many of the early, pioneering studies took place in sanitized “lab” environments, with subjects from Western countries, the past decade has seen an explosion of behavioral science research in the messier environment of the developing world. This work has given us greater insight into how and why the world’s poorest populations make the decisions they do. But perhaps more importantly, this work has allowed behavioral scientists to directly improve the well-being of the world’s poorest and most vulnerable populations.
Universitat Pompeu Fabra and BGSE Emeritus Research Professor Robin M. Hogarth shares some thoughts in the light of Prof. Thaler’s award of the Nobel Prize in economics.
What would you deem to be the most significant contributions of Prof. Thaler?
Prof. Hogarth: “I’m very glad that Thaler got the Nobel Prize, because it’s a recognition that the field of behavioral economics has to be taken seriously. He has made the field more popular and two of his books are quite interesting. Even though from an academic point of view ‘Nudge’ may not be so strong, in both ‘Nudge’ and ‘Misbehaving’ Thaler has done a very good job in explaining things and making behavioral economics accessible to the wider public. ‘Nudge’ has spurred the creation of nudge initiatives in the UK and the US.”
Prof. Thaler has greatly contributed in popularizing behavioral economics and manifesting the insight it can offer in practice and policy, especially though the use of nudges bringing nudge theory to prominence. However, as is most times the case with influential research, Prof. Thaler’s work has also been a matter of controversy, as criticism of what is called ‘libertarian paternalism’ has developed. Concerns have been raised both in regards to freedom of choice (e.g. Mitchell, 2005; Veetil, 2011) and the efficiency or optimality of paternalistic policies (e.g. Rachlinski, 2003; Mitchell, 2005; Glaeser, 2006).
How do you think concerns regarding the use of nudges can be alleviated? Do you think there needs to be any form of regulation on it?
Prof. Hogarth: “Thaler and his co-authors have supported nudge coining the term ‘libertarian paternalism’. Although I don’t think the term makes much sense, I don’t see what is wrong with governments saying that some things are better for people than others; advertisers do it all the time.
In some EU countries there is a total rejection of organ donation after death, while in others almost total acceptance and the reason is the difference in the default option on the driving license among countries. I don’t see why this is wrong; since a default has to be chosen, why not choose the one that is on average better for everybody? Provided that people can still go against the default, if they want to. Governments should be able to use as much social science knowledge as they want. As long as there is “good knowledge”, why should we ignore it? Whether it comes from sociology, psychology, anthropology, economics or whatever, we should use it, as long as it is good for the society.
I don’t think there is any need for regulation of nudge. One should not regulate how advertisers advertise the products, as long as they say the truth. Similarly, governments or agencies should be allowed to design choice; they just need to be honest and clear about it.”
Are there any other thoughts you would like to share in the light of this year’s awarding of the Nobel Prize in Economics?
Prof. Hogarth: “Another interesting aspect of Thaler’s work is that it has managed to make an impact without being heavily mathematical. The other point I would like to make is that Thaler owes a tremendous debt to Tversky and Kahneman. Prospect theory provided a framework for explaining things Thaler thought of.”
We kindly thank Prof. Hogarth for sharing these thoughts with us.
Glaeser, E. L. (2006). Paternalism and Psychology. The University of Chicago Law Review, 73(1):133-156
Mitchell, G. (2005). Libertarian Paternalism Is an Oxymoron. Northwestern University Law Review, 99(3):1245-1277.
Rachlinski, Jeffrey J. (2003). The Uncertain Psychological Case for Paternalism. Northwestern University Law Review, 93(3):1165-1225.
Veetil, V.P. (2011). Libertarian paternalism is an oxymoron: an essay in defence of liberty. European Journal of Law and Economics, 31: 321-334.
In recent decades, financial literacy has been gaining more and more research interest with experts emphasizing that it can be conducive to more efficient financial decision-making. Given the tough economic situation in many countries around the world after the global financial crisis, the need for financial literacy has become even more imperative. Through financial literacy people can both achieve higher levels of wealth and better allocate it in order to make the most out of it or, as an economist would say, maximize their utility.
Before we start to examine the ways, in which financial literacy can inform our decisions, we first need to define financial literacy. An integrative definition stressing both financial knowledge and the ability to put it in practice has been proposed by Remund (2010, p. 284), who defines it as
“a measure of the degree to which one understands key financial concepts and possesses the ability and confidence to manage personal finances through appropriate, short-term decision-making and sound, long-range financial planning, while mindful of life events and changing economic conditions.”
Financial literacy and behavioral economics enhancing financial decision-making
Financial knowledge can enhance decision-making by raising awareness about some common behavioral errors people are susceptible to, when making financial decisions. Estelami (2009) argues that financial literacy programs could fight typical financial decision-making errors, such as hyperbolic discounting, short-term memory overload, anchoring effects, inaccurate risk perceptions and mental accounting. Similarly, Loerwald and Stemmann (2016) suggest that, when people become aware of some common human decision-making errors, they can better resist to making them, while the importance of financial education and financial literacy is also stressed by Altman (2012) and Shen (2014), who addresses overconfidence, anchoring and framing effects.
Another major mistake people do is that they often hold under-diversified portfolios. The importance of portfolio diversification in mitigating risk and achieving optimal return and risk combinations has long been acknowledged both in academia and by investment professionals. This crucial role of portfolio diversification has become even better acknowledged, since Harry Markowitz’s –recipient of The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel in 1990– seminal paper Portfolio Selection(1952)*. However, studies have shown that many households and individual investors hold under-diversified portfolios.
Fortunately, based on empirical evidence it appears that individuals with higher financial knowledge possess better diversified portfolios (Goetzmann and Kumar, 2008; Calvet, Campbell and Sodini, 2007; Guiso and Jiappelli, 2009; Abreu and Mendes, 2010; Kimball and Shumway, 2010).
Struggling against bad financial decisions
Nevertheless, as Estelami (2009) underlines, knowledge of financial matters cannot guarantee success in our financial decisions, as behavioral errors and biases in these decisions are often found to affect even the most financially knowledgeable. The father of Modern Portfolio Theory, whom we met just above, Harry Markowitz, admitted that he had used the 1/N heuristics or naive diversification; that is, he simply assigned equal weights to all assets in his portfolio without for example looking at the correlations among the included assets. He attributed this decision to regret aversion: “My intention was to minimize my future regret, so I split my retirement plan contributions 50/50 between bonds and equities.” (Mitra, 2003; Pompian, 2012).
What’s the takeaway?
Financial literacy and knowledge of our psychological and cognitive biases and errors are key factors that can help us lead a wealthier life. However, the battle against bad financial decisions is not a piece of cake for any of us. The best we can do is to start this learning journey in financial literacy and behavioral economics -which hopefully you have already done by clicking on these eye-catching hyperlinks in the text. That way, the next time we are buying a new 20.000€ car and are presented with these gorgeous 2.000€ accessories to buy with (because “come on, it’s peanuts, I’m already spending 20.000€ on the car”), we will know that we may be falling for mental accounting and “bundling”. Therefore, we need to think twice if we value these accessories that much; maybe these 2.000€ spent on something else would finally prove to be much more useful and make us a lot happier!
Note: The idea for the last example comes from the lecture Mental Accounting and Expenditures of the free online course Behavioral Finance, which you may well want to enjoy by clicking here.
*The concept of diversification had been known for many years before, but Markowitz’s work provided a solid theoretical framework and helped lay the foundations of Modern Portfolio Theory. For an assessment of the early history of portfolio theory, see Markowitz (1999).
Altman, M. (2012). Implications of behavioural economics for financial literacy and public policy. The Journal of Socio-Economics, 41(5), pp.677-690.
Estelami, H. (2009). Cognitive drivers of suboptimal financial decisions: Implications for financial literacy campaigns. Journal of Financial Services Marketing, 13(4), pp.273-283.
Loerwald, D. and Stemmann, A. (2016). Behavioral Finance and Financial Literacy: Educational Implications of Biases in Financial Decision Making. In: C. Aprea, E. Wuttke, K. Breuer, N. Koh, P. Davies, B. Greimel-Fuhrmann and J. Lopus, ed., International Handbook of Financial Literacy, 1st ed. Springer Singapore, pp.25-38.
Markowitz, H. (1999). The Early History of Portfolio Theory: 1600-1960. Financial Analysts Journal, 55(4), 5-16.
Rasiel, E. & Forlines, J. (2016). Mental Accounting and Expenditures. Lecture, Behavioral Finance by Duke University on coursera.org.
Shen, N. (2014). Consumer rationality/irrationality and financial literacy in the credit card market: Implications from an integrative review. Journal of Financial Services Marketing, 19(1), pp.29-42.
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